Whole life and other cash value life insurance policies have the flexibility to allow policy owners to borrow from the cash value that builds inside their policy, but is taking a loan a good idea? It’s important to understand the consequences of taking a loan first. Let’s take a look at some pros and cons.

Advantages

• Loans don’t have to be paid back. The money withdrawn is deducted from the death benefit.
• Loans are potentially tax free. The loan is not reported for tax purposes unless the policy is surrendered or lapses.
• Loans are flexible. The repayment schedule can be modified as needed.
• Getting a loan can be relatively simple. Usually, a form from the insurance company is that is needed to initiate a loan. Also, there’s no credit check.

Disadvantage:

• While the repayment terms are flexible and the loan doesn’t have to be paid back, the unpaid interest accumulates, compounds, and may further reduce the death benefit of the policy or place the policy in danger of lapsing.
• The reduction in death benefit by the outstanding loan may leave you underinsured.
• When loans aren’t monitored, a large and unexpected tax consequence can occur when a policy gets surrendered or lapses.

When borrowing from policies, individuals occasionally forget about the loan or stop paying it back. This can create a taxable event on the amount of gain in the policy. In addition, unpaid interest on a policy can lead to “phantom income,” which could be taxable even though a taxpayer didn’t receive the funds.

A 1099 tax form is created by the insurance company when a policy lapses and the loan amount is more than the basis. For life insurance purposes, basis is defined as the total amount of lifetime premiums paid in minus dividends received. Let’s look at a quick example:

You have been paying $200/month into a universal life insurance policy for the past 10 years, for a total of $24,000 in premiums. You decide to stop paying the premiums and take a loan for $40,000. The interest brings the outstanding balance up to $50,000. The policy lapses and is cancelled by the insurance company. You will owe ordinary income taxes on $26,000, the difference between the $50,000 balance and $24,000 in premiums.

Cash value can be a readily accessible source of funds when needed, but as with most financial decisions, you should consider the specifics and consequences of your individual situation before making a decision.